ECB To Hike, Market to Move on Outlook
It is near certain that the ECB will hike at the end of its meeting on Thursday, but there is considerable uncertainty about what happens afterwards. The market reaction is likely to depend on more complex factors than a simple hike or no-hike outcome, as traders focus on revised staff projections and President Christine Lagarde’s comments.
ECB officials have been uncharacteristically quiet in the weeks leading up to the decision, at least in terms of policy. Expectations are instead based on data, with rising inflation as the main impetus for the general agreement that more tightening is coming. However, how different sectors interpret that data in the medium term varies, and that could produce a market swing in the aftermath of the decision.
Economists and the Market Disagree
Markets are pricing in two more rate hikes in the year following Thursday, with the next as soon as December. This contrasts with the outlook by major European banks and many economists, who expect an extended pause after this week’s hike. The key to the market reaction will likely depend on which path the ECB signals it is on.
One of the reasons for the disagreement is the difference in inflation readings. Flash August CPI went in opposite directions, with the headline rate rising and the core declining. The differentiator was energy, which saw a 14% increase, pressuring headline inflation higher. However, the drop in the core rate implies that there has been little pass-through to the broader economy, a phenomenon observed in other countries to the surprise of many analysts.
The ECB’s Mandate Could be Key
One thing that traders often forget is that the ECB pays close attention to core inflation but is not mandated to base its decisions on it. The central bank’s mandate is simply price stability, and the core rate is often (but not always) a better measure of long-term price trends than the headline rate.
Therefore, the ECB could be more concerned about accelerating headline inflation than other central banks, particularly as the Eurozone economy picks up since bottoming out earlier this year. That would justify expectations that rates will continue to rise through the rest of the year. On the other hand, economists and analysts at major banks typically have a better read on what the central bank is thinking simply because they share a similar background and thought process.
How the Market Could React to the ECB Decision
Since the odds of a rate hike are at 99%, barring a hold, which would be a major dovish surprise, the focus will be on two factors: Lagarde’s comments and the inflation outlook. Alongside the rate decision, the ECB will update its economic projections for this year and next. If the inflation outlook is raised, the market will likely take it as confirmation of a rate hike in December, boosting the EUR.
On the other hand, if the inflation outlook is maintained or even cut, the market’s takeaway will likely be dovish, and the EUR could weaken. Likewise, if Lagarde sounds more ambivalent about inflation (for example, expressing concern but not saying it’s accelerating), the market could also have a dovish response.
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